Menu

Cycles & Markets

Suppose that you owned a partnership interest in a business, and that your business partner was readily available any day to either buy out your half of the business or sell his half to you—as long as the price was right.

Suppose, though, that your partner suffered from erratic mood swings. He can quote you the price he’ll buy or sell for any time, but his appraisals are always colored by his current mood. When business is good he over-values the business and offers you the moon for your half of the business; when business is poor he becomes pessimistic and offers to sell you his share for pennies on the dollar.

This is a metaphor Warren Buffett uses in his shareholder letters to describe the stock market from the investor’s perspective, dubbing our hypothetical business partner “Mr. Market.” As a stock holder you have an ownership interest of a tiny slice in a business. There is a market to buy or sell shares of the business at almost any time. But the price the market may give you depends on investor moods.

According to Buffett, if you understand the value of a business it’s in your best interest to take advantage of Mr. Market’s mood swings to trade when his prices are at their most irrational. However, he also offers this warning:

“But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”

So when the market is in a frenzy of buying or selling, there may be opportunities to profitably take advantage of the stampede—but not to join it.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Stock investing involves risk including loss of principal. No strategy assures success or protects against loss.

In our quest to make sense of the world, one recurring theme is the potential gap between expectations and reality. We humans do one thing very well: we love to take things too far. Thus we have bubbles, manias, and fads, unrealistic expectations and the Kardashians.

When there is a universal expectation of something, the expectation can be said to be “already in the price.” If the expectation comes to pass, there will be little impact on the market. If reality unfolds differently, however, the market will move.

For example, several years ago when all the Washington news was about the “fiscal cliff,” the country needed Congress to do the right thing to avoid catastrophe. Congress ranks in public estimation somewhere lower than a snake’s belly, so the consensus expectation was for catastrophe. The markets performed poorly as a result.

But as the deadline approached, it seemed evident to us that expectations were SO low, there was very little chance that Congress could perform worse than expected. We expected Congress to produce a catastrophe, and that expectation was “already in the price.” If Congress either did as expected or better, the market might remain steady or go up. Since Congress could hardly do worse than expected, we felt that actual risk was lower than most others perceived.

This understanding enabled us to stay the course amidst great uncertainty, to our benefit.

One of the most-talked about issues today is whether or when the Federal Reserve Board will raise interest rates. We all know that this will happen sooner or later; this knowledge is presumably already in the market. Hence, we see little advantage in fussing over the probabilities.

When something happens that everyone knows was going to happen, there usually is not a big effect on the market. So we spend our time trying to find unexpected opportunities instead of expected problems.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Listening to the news, you’d never know this. When gas hit $4 a gallon several years ago, headlines said it would go to $7 or more—but instead of doubling, prices fell by half. This shouldn’t be a surprise, especially for those of us old enough to remember the oil crisis of the 1970s. The glut of oil we see today is really just a symptom of the shortage a few years back.

When gas is scarce and prices are high, nobody wants to use any. People drive less, take fewer trips, and buy more efficient cars. At the same time, oil producers start falling over themselves to drill everything in sight. Eventually, the high prices cause demand to shrink and supply to grow.

We know what comes next: oversupply and plummeting prices. Now producers are spending too much money pumping cheap oil and have to close down plants. At the same time, people get used to cheap gas and start burning it freely. Truck and SUV sales go through the roof and people drive more miles. We think we know how this one ends, too.

Every glut plants the seeds of the next shortage, and every shortage plants the seeds of the next glut. We can see this happening in real time with oil and other natural resources such as iron and copper. It holds just as true with every other market in every other age—cattle, corn, and cars, smartphones and other gadgets, even abstract “goods” like movies and music.

Timing is nearly impossible to predict, and investments can be volatile and difficult to own. But by understanding how the process works, patient investors may profit. Today’s bust may be tomorrow’s boom.

Warren Buffett, the Oracle of Omaha, is a widely acclaimed investor and businessman. He is not perfect and he has been controversial at times. However, to our knowledge Buffett has made more money investing than any other human being on the planet. So he has that going for him, which is nice.

Almost 40 years’ worth of Buffett’s annual shareholder letters are available at www.berkshirehathaway.com. They provide a wealth of information on his views, methods, and insights. Some things from 1977 have gone away, like VHS tapes and KC & The Sunshine Band, but Warren Buffett’s letter for that year contains some timeless insights.

“Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day.”

He goes on to write,

“We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”

Notice that his focus is on the business, not the stock. Buffett did not build his fortune by worrying about short term price swings. He considers his investments in terms of many years, not day to day prices. And he understands that the best way to build wealth for himself and his investors is to buy great companies at bargain prices. For Buffett, falling prices are a buying opportunity rather than a source of pain and anguish.

Buffett’s insight is remarkable in a market dominated by short-term trends—as are his results. There is a lot of wisdom in these words, and we will frequently return to Buffett’s letters as a source of guidance. In the meantime, like Buffett, we continue to seek the best bargains on the market and cultivate our investment “orchard” for long-term growth rather than trying to sell if for short-term reasons.

Investing involves risk including loss of principal. No strategy assures success or protects against loss.

A long time ago, a toddler posed me the above question. Surprised, I said “What?” and she replied, “The world!” The innocent quest of a three-year-old to observe and understand the world as it is contains a vital lesson for investors. The corresponding question for investors, one that deals with the most basic aspect of the economic and business world and the investment markets, is “Ever notice that it goes up-down, up-down, up-down?”

Cycles and volatility are every bit as central to the investing world as night and day are to the physical world. When the sun sets, we know better than to panic about whether it will ever rise again. When the markets turn downwards it is equally fruitless to worry that they are going to stay down forever.

It is important to have the wisdom to recognize that markets don’t go up forever, either. Investors are lured into bubbles by the notion that the good times are here to stay. How many people did you hear saying “You can’t lose money in real estate” in 2007, or “You can’t lose money in tech stocks” in 2000? They might as well have been saying that the sun will never set.

We know that the market goes up-down, up-down, up-down. While markets may not be as reliable as the sun, we believe that over the long run we can see more “up” than “down.” Part of this is knowing enough to avoid stampedes when everyone else is convinced that a market can only go up-up-up or down-down-down.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.